SPX Levitation Act

Over the last few months, the behavior of the US stock markets has been rather vexing. Usually when they grow overbought, when greed and complacency wax extreme after a powerful rally, a healthy pullback soon rebalances sentiment. But instead they've ground higher lately, defying precedent and confounding students of the markets.

Back in mid-October, the flagship S&P 500 (SPX) had blasted 24.9% higher in just over 3 months since the end of its summer pullback. It had stretched 20% beyond its 200-day moving average, incredibly extreme territory never even approached in the entire last cyclical bull. Complacency was so great that the VXO implied-volatility fear gauge fell to 20. Probabilities overwhelmingly favored an imminent retreat.

But curiously, the overdue SPX pullback never came. Even though trading volume waned dramatically, buyers who missed the epic rally since March were still moving enough capital into stocks to offset the meager selling pressure. The result was a strange SPX levitation act, the stock markets staying high despite very overbought technicals and ever-ballooning complacency.

As a student of the markets and speculator, I've been waiting 3 months for this pullback that never came. If you study the history of most technical or sentiment indicators, in the past when they reached the levels they've somehow sustained in recent months a sharp pullback was soon to follow. But the markets are full of surprises, and so far today's retreat hasn't materialized.

Given the persistently overbought states of so many markets today, I still believe probabilities overwhelmingly favor a universal pullback in stocks and commodities to rebalance sentiment. The reasons are legion, and it could be triggered any day now by some yet-unknown catalyst. Nevertheless, traders must adapt. We have to accept the markets as they are, not as history teaches they ought to be.

The SPX's nonchalant behavior so far in January, edging higher to new post-panic closing highs on each of this year's first 6 trading days, was so rare that alternate scenarios must be considered. So this week I was wondering if there is precedent for the stock markets to grind higher, sans meaningful pullback, after such a powerful rally. Interestingly enough, there is! We've seen this show before.

Today the stock markets are in a young cyclical bull within a secular bear. Understanding this is crucial for investors and speculators, and I wrote an essay on it back in June if you need to get up to speed. To research whether this surreal SPX levitation act might actually be sustainable, I compared today's markets to the same early point in the lifespan of the last cyclical bull (which essentially ran from March 2003 to October 2007). It turns out the symmetry and comparisons are uncanny.

In this chart, the S&P 500's current cyclical bull rendered in blue is superimposed over its last cyclical bull in red. Even though our current bull emerged out of an ultra-rare stock panic, while the last one was born after a far-more-common cyclical bear, these rallies' similarities are remarkable. The SPX is not only rallying in almost the same way, but it is passing the same levels at nearly the same times.

Both cyclical bulls emerged out of deeply oversold lows in March. While the panic-driven despair lows of March 2009 were far more extreme than the more typical bear-driven lows of March 2003, it is provocative that these parallel SPX bottoms happened within a single trading day of each other across the 6-year gulf! Coincidences like this really make you wonder about the little-understood impact of deep psychology seasonality.

Back in March 2003, the markets were worried about Washington's imminent invasion of Iraq. While it seems trivial in hindsight, pre-invasion Iraq had the fourth-largest standing army in the world. Traders feared catastrophic oil-flow disruptions when the Scud missiles started flying. But in March 2009, all we had to fear was fear itself. A deep despair driven by stock-panic-spawned economic worries had set in. The backdrops couldn't have been more different, yet the cyclical bulls started at the same time.

Both cyclical bulls saw blisteringly-fast early rallies, which are typical and expected after deeply oversold fear-laden lows. Note above how closely the steep rallies between March and May parallel each other. Then in June, both cyclical bulls temporarily ran out of steam. The 2003 one was up 26.3% since March and the 2009 one 39.9% (coming from much deeper lows). Yet they both topped within 2 trading days of each other in June, which is fascinating.

These infant bulls certainly weren't over, but all bulls need to rest from time to time. Periodic pullbacks are healthy and necessary to bleed off excessive greed and ensure the bull doesn't burn itself out prematurely. This is a real threat if greed is unchecked for so long that all buyers interested in buying soon are sucked in, leaving no one else to buy. So every few months or so healthy pullbacks tend to erupt, which is why one looked so probable in October 2009.

After their initial rocketing ascents tapered off in early June, both bulls retreated in June and July to rebalance sentiment. The SPX's 7.1% pullback over 19 trading days ending in mid-July 2009 was the last meaningful pullback in our current cyclical bull. After these rebalancing pullbacks, both bulls were off to the races again in late summer and early autumn. Amazingly, their intra-month patterns are nearly identical. Early-month rallies were followed by mid-month interim highs and subsequent late-month selling.

In late October 2009, the SPX fell 5.6% in 9 days which was the last material selling episode we've seen. But it wasn't quite big enough to reach the meaningful-pullback zone (say from 7% to 10%). Then in November and early December, both cyclical bulls generally ground sideways near their highs. But midway through December, both started rallying again. This strength carried into early January in both cases.

Over the years I've created thousands of custom charts to explore tradable interrelationships in the markets. And even within this large pool of work, this chart strikes me as exceptional. It is amazing that two completely different cyclical bulls, born in very different economic conditions, would so precisely mirror each other on a month-to-month basis. And at nearly the same levels on the SPX, no less! Despite the endless differences between 2003 and 2009, these young cyclical bulls evolved very similarly.

And this brings us back to today's SPX levitation act. Despite its sheer oddness, there is precedent for markets staying overbought and complacent at this point in cyclical bulls. This weakens the imminent-pullback thesis, forcing investors and speculators to consider an alternate near-future where the stock markets aren't sold off aggressively. What could it look like? There is no better example than 2004.

Just as 2003 is the last cyclical bull's equivalent to 2009, 2004 is equally analogous to 2010. And the red line above chronicling 2004's behavior could very well prove as prophetic for 2010 as 2003's path did for 2009. Right about where we are today, 1150 on the SPX, the advance flattened out between late January and early March. The US stock markets started grinding sideways right near their highs. While overbought then too, much like today there was still enough buying to offset selling pressure.

After that, the SPX started a slow grind lower which persisted for almost 6 months into mid-August. That meandering 2004 span saw several pullbacks noted above. There was a 5.7% one over 29 trading days ending in March, soon followed by another 5.8% one over another 29 days ending in May, and then a final larger 7.1% one over 35 days ending in August.

Now I think we have to be careful here and not read too much into the precise timeline of 2004's grind lower. Nevertheless, its strategic implications are important. After such an amazingly powerful run higher, even if there isn't a meaningful pullback or full-blown correction (say 10%+), the piper still has to be paid. Overbought hyper-complacent markets can't persist, sentiment must be rebalanced one way or another.

And there are only two ways to bleed off greed and complacency, correction and consolidation. The former works rapidly via the mechanism of a sharp retreat that quickly stokes fear among traders. The latter works slowly, as sideways-grinding prices transform excessive greed into boredom and apathy. Either way greed is rebalanced away, with a tradeoff between the sharpness of selling and time elapsed.

This year we are likely to see stock markets structurally similar to those of 2004. The SPX will probably grind sideways, although I'm not sure if the bias will be slightly to the upside or slightly to the downside. There are many arguments for an upside bias to this consolidation including the vast pools of cash remaining on the sidelines earning nothing in this zero-rate environment. The Fed continues to try and force idle capital to migrate into stocks by strong-arming money-market yields to nil.

But on the other side, a downside bias is probable too. We continue to languish under very high unemployment rates, this economic recovery is tepid at best. On top of this, the freedom-hating Marxists running Washington are aggressively trying to raise already-crushing income taxes on top of imposing asinine new taxes on everything from electricity to health insurance to banks. Stealing more money from hard-working American taxpayers to bribe others for votes creates a very negative investing environment.

So I really don't know how to game the consolidation grind, it could gradually meander higher, stay flatlined, or slump lower. But it will almost certainly be punctuated by periodic pullbacks just like the 2004 consolidation was. Based on that precedent, we should expect several this year running in the 5%-to-7% range. This is a significantly different alternative from the larger meaningful pullback in the 7%-to-10%+ range that conventional market analysis (ignoring the cyclical-bull lifespan) suggests is coming.

Provocatively, 2004 certainly isn't the only precedent for a grinding, consolidating 2010 emerging at this stage in our young cyclical bull. During the last secular bear, from 1966 to 1982, a cyclical bull emerged in October 1974. Not only was it very similar to today's, born after a near-panic plunge, it started at the same point in that last secular bear where we were in late 2008 in our current secular bear. Once again, it is utterly imperative you internalize and understand this cyclical-bulls-and-bears-within-secular-bears concept.

Today's SPX is again rendered in blue, this time superimposed over the last secular bear. You can clearly see the bull-bear cycle here, cyclical bears followed by cyclical bulls within the confines of the SPX's giant secular trading range between roughly 750 and 1500. While the markets grind sideways on balance for 17 long years in secular bears, they are cut in half and then doubled within this mighty trading range.

In our current secular bear's lifespan, 2010 is the rough equivalent of 1976. Back then there was a very sharp rally in 1975 (2009 equivalent) which stalled out in early 1976. While the SPX didn't surrender its gains back then, it didn't go higher either. It flattened and ground sideways in a high consolidation very similar to 2004's. Here we have yet another example of an odd SPX levitation act.

Despite this chart not having zeroed axes, the relative trading ranges across these different decades aren't distorted. You can see a zeroed-axis version of this chart back in my June essay if you want to verify this yourself. If you translate 1976's behavior into today's SPX terms, the markets spent most of the year grinding sideways to slightly higher (roughly between 1075 and 1150). It wasn't until late in the year that the 1200 equivalent was approached. This is very similar to 2004's model.

So in the second year of a cyclical bull, after the initial year's skyrocketing rally exhausts itself, there is plenty of precedent for sideways-grinding markets. We saw them in 2004 at the same stage in the last cyclical bull. And we saw them in 1976 at the same stage in the last secular bear. Despite speculators like me expecting a meaningful pullback to rebalance sentiment, 2010 may simply grind sideways instead.

While I accept this precedent and will alter my trading strategy accordingly, corrections are much better than consolidations for investors and speculators. Corrections are not only over fast, but they provide great buying opportunities when they mature. Hit the markets fast, hit them hard, and kill the greed quickly so rallying can resume again. But consolidations are boring life-sapping affairs that lead to dull markets and relatively few trading opportunities. They burn valuable time and force us into waiting mode.

Prior to this research, based on sentiment and technical indicators I figured we had an 80% to 90% chance of a sharp and meaningful pullback soon. Now those odds have to change. I'm not willing to fully dismiss the sharp-correction thesis, but the high-consolidation thesis is equally compelling at this particular stage in a cyclical bull. If pressed, I'd probably now game it at 45% correction odds and 45% consolidation odds. And the longer the SPX grinds sideways, the higher the latter chances will rise.

While boring sideways markets are a heck of a lot less fun than fast-moving ones, prudent investors and speculators can still thrive. The key is carefully picking stocks with great fundamental prospects that are likely to rise over time no matter what the headline SPX does. At Zeal, we are constantly working on deep-research projects into commodities stocks to find our fundamental favorites in promising sectors. We just published a fascinating new report on our favorite junior base-metals stocks. Buy yours today!

In our new January Zeal Intelligence newsletter, we bought a junior profiled in this report. It is a tiny and largely-unknown company that owns the world's largest primary deposit of a secondary base metal that is soon to gain a lot of publicity as futures are launched on it. In just 8 trading days as more investors learned of its potential, this stock has already risen 33%. This is nothing though, as it has the potential for 10x to maybe even 100x gains in the coming years. Subscribe today, learn about the markets and trading opportunities, and become an informed investor!

The bottom line, much to my chagrin, is there is plenty of historical precedent showing stock markets consolidating high after their initial sharp rallies following the births of cyclical bulls. Buyers are exhausted after these massive moves higher, but few traders want to sell so the dwindling capital inflows are still generally able to neutralize selling pressure. The result is slowly meandering (and intensely boring) stock markets. But on the bright side, if sharp pullbacks aren't igniting big fear spikes, investors gradually bid up fundamentally-promising companies.

So prudent stock pickers can thrive in these sideways environments, buying elite stocks before the thundering herd discovers them. While there are still significant odds for a fast pullback to scare away today's hyper-complacency, we have to start adapting our trading strategies to the growing chances for a grueling high consolidation instead. As wrong as it feels, this surreal SPX levitation act could persist.

Adam Hamilton, CPA

Zealllc.com

January 15, 2010

Also by Adam Hamilton

So how can you profit from this information?  We publish an acclaimed monthly newsletter, Zeal Intelligence, that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research.  Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm

Questions for Adam?   I would be more than happy to address them through my private consulting business.  Please visit www.zealllc.com/adam.htm for more information.

Thoughts, comments, or flames?  Fire away at zelotes@zealllc.com.  Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally.  I will read all messages though and really appreciate your feedback!

Copyright 2000 - 2006 Zeal Research (www.ZealLLC.com)